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Unformatted text preview: Capital Budgeting Capital Decision Criteria Mind Map Mind
s Why?: Think about it – the firm’s current balance sheet is the result of past capital budgeting decisions. Perhaps the most important decision managers make is determination of which capital projects to accept. In this section, we analyze the methods used for making these important capital budgeting decisions. Mind Map Mind
s Learning objective:
– Articulate the desired attributes of a capital Articulate budgeting methodology budgeting – Determine whether a project is acceptable Determine based on payback, NPV, and IRR based – Discuss the weaknesses of payback and IRR Discuss Mind Map Mind
s Key words/concepts:
– – – – Payback period Net present value Internal rate of return Cash flow patterns Cash Capital Budgeting: the process of Capital planning for purchases of longterm assets. assets.
s example: Suppose our firm must decide whether to purchase a new plastic molding machine for $127,000. How do we decide? do Decisionmaking Criteria in Capital Budgeting Capital
s The Ideal Evaluation Method should: a) include all cash flows that occur a) all during the life of the project, during b) consider the time value of money, b) time c) incorporate the required rate of c) return (i.e., Risk) on the project. return Payback Period Payback
s The number of years needed to The recover the initial cash outlay. recover s How long will it take for the project How to generate enough cash to pay for itself? itself? Payback Period Payback
s How long will it take for the project How to generate enough cash to pay for itself? itself?
(500) 150 150 150 150 150 150 150 (500) 150 0 1 2 3 4 5 6 7 8 Payback Period Payback
s How long will it take for the project How to generate enough cash to pay for itself? itself?
(500) 150 150 150 150 150 150 150 (500) 150 50 150 0 1 2 3 4 5 6 7 8 Payback period = 3.33 years. Payback s Is a 3.33 years payback period good? s Is it acceptable? s Firms that use this method will Firms compare the payback calculation to some standard set by the firm. some s If our senior management had set a If cutoff of 4 years for projects like ours, what would be our decision? ours, Drawbacks of Payback Period: Drawbacks
s Firm cutoffs are subjective. Firm subjective s Does not consider time value of money. Does time s Does not consider any required rate of Does return. return s Does not consider all of the project’s Does cash flows. cash Drawbacks of Payback Period: Drawbacks
s In capital budgeting, there are two kinds In of mistakes that can be made: of
– Reject a good project – Accept a bad project
s Payback is subject to both! Drawbacks of Payback Period: Drawbacks
s Does not consider all of the project’s Does cash flows. cash
(500) (500) 50 50 50 50 30000 0 0 0 1 2 3 4 5 6 7 8 Drawbacks of Payback Period: Drawbacks
s Does not consider all of the project’s Does cash flows. cash
(500) (500) 50 50 50 t a go R e jec 50 30000 0 oject! od pr 0 0 1 2 3 4 5 6 7 8 Consider these cash flows. If the cutoff is 4 years, this project would be rejected! Drawbacks of Payback Period: Drawbacks
s Does not consider all of the project’s Does cash flows. cash
(500) (500) 5 5 5 490 0 0 0 0 1 2 3 4 5 6 7 8 Drawbacks of Payback Period: Drawbacks
s Does not consider all of the project’s Does cash flows. cash
(500) (500) 5 5 5 A 490 0 t a ba c ce p je c t! d p ro 0 0 0 1 2 3 4 5 6 7 8 Consider these cash flows. If the cutoff is 4 years, this project would be accepted! The Best Methods The
1) Net Present Value (NPV) 1) Net 2) Internal Rate of Return (IRR) 2) Internal Each of these decisionmaking criteria: s Examines all net cash flows, s Considers the time value of money, and s Considers the required rate of return. Net Present Value Net
• NPV = the total PV of the annual net NPV cash flows  the initial outlay. cash NPV = Σ
t=1 n ful ns! are sig C th wi CFt CF (1 + k) t  IO Net Present Value Net • Decision Rule: • If NPV is positive, ACCEPT. If ACCEPT • If NPV is negative, REJECT. If REJECT NPV Example NPV
s Suppose we are considering a capital Suppose investment that costs $27,400 and provides $27,400 annual net cash flows of $8,000 for four years $8,000 and $16,000 at the end of the fifth year. The $16,000 firm’s required rate of return is 15%. 15%. NPV Example NPV
s Suppose we are considering a capital Suppose investment that costs $27,400 and provides annual net cash flows of $8,000 for four years and $16,000 at the end of the fifth year. The firm’s required rate of return is 15%. firm’s 8,000 8,000 8,000 8,000 16,000 (27,400) 0 1 2 3 4 5 NPV with the HP10B: NPV
s 27,400 27,400 s 8,000 8,000 s4 s 16,000 16,000 s 15 15 s shift CFj CFj CFj CFj shift Nj shift CFj CFj I/YR I/YR NPV s You should get NPV = 3,395 You 3,395 NPV with the TI BA II Plus NPV
The NPV of the capital investment is: [CF] [2nd] [CLR WORK] CF0 = CF1 = FO1 = CF2 = FO2 = 27,400 8,000 4 16,000 1 [+/] [ENTER] [↓ ] [ENTER] [↓ ] [ENTER] [↓ ] [ENTER] [↓ ] [ENTER] [↓ ] Press the [NPV] button and then enter 15 where it says I =. Press [ENTER] [↓ and then [CPT] and you should ] get the result $3,395. NPV THOUGHT QUESTION NPV
s Suppose you are evaluating a nuclear Suppose power plant. The initial outlay is $6,000,000,000. The cash flows are spread out over 40 years. You do all the necessary analysis, discount the CFs at 11%, perform extensive sensitivity analysis, and finally calculate a NPV of $3.35. Would you really invest $6 Billion is earn $3.35? is THOUGHT FOR THE DAY THOUGHT
s s s George Bernard Shaw: “People are always George blaming their circumstances for what they are. I don’t believe in circumstances. People who get on in this world are the people who get up and look for the circumstances they want, and, if they can’t find them, make them.” they Elder Ballard: I am a great believer that what Elder you and I think about will ultimately come to pass … I believe if we think about what it takes to be successful long enough and if we are willing to discipline ourselves to the principle of success, we will experience success. success, Point: Get off your rump and make it happen! Get Internal Rate of Return (IRR) Internal
s IRR: IRR is simply the rate of IRR return that the firm earns on its capital projects. capital s That is, the IRR is the rate of That return that makes the NPV equal to zero. equal Internal Rate of Return (IRR) Internal NPV = Σ
t=1 n CFt CF (1 + k) t  IO Internal Rate of Return (IRR) Internal NPV = Σ
t=1 n n CFt CF (1 + k) t  IO IRR: Σ
t=1 C Ft t (1 + IRR) = IO Internal Rate of Return (IRR) Internal IRR: t=1 s IRR is the rate of return that makes the IRR PV of the cash flows equal to the initial equal outlay. outlay. s This looks very similar to our Yield to This Maturity formula for bonds. In fact, YTM is the IRR of a bond. is Σ n C Ft t (1 + IRR) = IO Calculating IRR Calculating
s Looking again at our problem: s The IRR is the discount rate that The makes the PV of the projected cash flows equal to the initial outlay. equal
8,000 (27,400) 8,000 8,000 8,000 16,000 0 1 2 3 4 5 (27,400) 8,000 8,000 8,000 8,000 16,000 0 1 2 3 4 s This is what we are actually doing: 5 8,000 (PVIFA 4,, IRR) + 16,000 (PVIF 5,, IRR) 4 5 8,000 16,000 = 27,400 27,400
Solve for the discount rate! (27,400) 8,000 8,000 8,000 8,000 16,000 0 1 2 3 4 5 s This is what we are actually doing: 8,000 (PVIFA 4, IRR) + 16,000 (PVIF 5, IRR) IRR IRR 8,000 16,000 = 27,400 27,400
s This way, we have to solve for IRR by trial This and error. and IRR with your Calculator IRR
s IRR is easy to find with your IRR financial calculator. financial s Just enter the cash flows as you did Just with the NPV problem and solve for IRR. IRR. s You should get IRR = 19.61%! You IRR IRR with the HP10B: IRR
s 27,400 27,400 s 8,000 8,000 s4 s 16,000 16,000 s shift CFj CFj CFj CFj shift Nj shift CFj CFj IRR s You should get IRR = 19.61%. You 19.61% IRR with the TI BA II Plus IRR
The IRR of the capital investment is: [CF] [2nd] [CLR WORK] CF0 = CF1 = FO1 = CF2 = FO2 = 27,400 8,000 4 16,000 1 [+/] [ENTER] [↓ ] [ENTER] [↓ ] [ENTER] [↓ ] [ENTER] [↓ ] [ENTER] [↓ ] Press the [IRR] button and then [CPT] and you should get the result 19.61% IRR IRR
• • Decision Rule: If IRR is greater than or equal to If the required rate of return, ACCEPT. ACCEPT If IRR is less than the required If rate of return, REJECT. REJECT • s IRR is a good decisionmaking IRR tool as long as cash flows are conventional. ( + + + + +) conventional (s Problem: If there are multiple Problem: sign changes in the cash flow stream, we could get multiple IRRs. ( + +  + +) ( s IRR is a good decisionmaking IRR tool as long as cash flows are conventional. ( + + + + +) conventional (s Problem: If there are multiple Problem: sign changes in the cash flow stream, we could get multiple IRRs. ( + +  + +) ((500) 0 200 1 100 2 (200) 3 400 4 300 5 s Problem: Problem: If there are multiple sign changes in the cash flow stream, we could get multiple IRRs. ( + +  + +) (s We could find 3 different IRRs!
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(you need one!) s Given the following cash flows: – Find the IRR. Find IRR – Using a discount rate of 15%, find NPV. Using NPV (900) 0 300 1 400 2 400 3 500 4 600 5 Summary Problem: Summary
s IRR = 34.37%. IRR 34.37%. s Using a discount rate of 15%, Using NPV = $510.52. $510.52. (900) 0 300 1 400 2 400 3 500 4 600 5 ...
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 Winter '11
 JimBrau
 Finance, Balance Sheet, Internal Rate Of Return (IRR)

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